Derivatives: Markets, Valuation, and Risk Management

CHAPTER 2

Assumptions and Interest Rate Mechanics

This book deals with risk management using derivatives. Effective risk management, however, requires accurate risk measurement, and accurate risk measurement requires a thorough understanding of valuation. The purpose of this chapter and the next is to review the fundamental principles of security valuation. This chapter focuses on the key assumptions that underlie security valuation models and reviews the use of interest rate mechanics in moving expected future cash flows through time. The next chapter focuses on estimating appropriate discount rates for securities given their risk characteristics.

The outline of this chapter is as follows. The first section presents the set of assumptions that underlie our valuation framework. The second section deals with the interest rate mechanics that allow us to move cash flows through time. The third and fourth sections then apply the assumptions and interest rate mechanics to value fixed income securities—discount bonds and coupon bonds. The fifth section focuses on the relation between interest rates and term to maturity as well as the meaning and computation of forward rates of interest. The sixth section describes common stock valuation. The chapter concludes with a summary.

UNDERLYING ASSUMPTIONS

Building valuation models requires making assumptions. Two assumptions that lay the foundation for security valuation are the absence of costless arbitrage opportunities and frictionless markets. ...